Covenant Weekly Market Synopsis 1.13.17

January 13, 2017

The Trump reflation trade lost some steam last week (and more this morning), although it is worth noting that broad equity indices in the U.S. and internationally have already posted gains of around 2% or better thus far in 2017. The yield on US Treasuries declined a titch, in a continuation of the moderating yield trend that began the day after the Fed raised rates by 0.25% on December 15. Since then the yield on the 10-year bond has declined to 2.40% (from 2.60%), while the long bond (the 30-year bond) has declined to 2.99% (from 3.18%). Evidently the “smart money” doesn’t yet believe in the narrative that excessive inflationary pressures are building in the economy. It is also worth noting the yield curve has been flattening recently (the chart below illustrates the spread between UST 30 year bonds and UST 2 Year bonds), defying expectations that Trump’s policies will create inflation and higher long-term yields. This is a volatile series and not too much should be read into a short data set, except that a continuation of this trend would create a headwind for bank earnings who generate much of their lending profits by capturing the yield differential between borrowing money at the short end of the curve and lending it at the long end (e.g. through mortgage lending). As the longer-term chart shows, the yield differential remains compressed compared to the last seven years, and the recent rally in banking stocks was predicated largely on a belief that this spread will widen under Trump’s administration.

Game On! – This Friday, president-elect Trump will officially take the reins of the most powerful nation in the world. From a financial perspective, he will inherit an economy that is on decent footing, but has yet to achieve sustained growth above 3% per year. There is no shortage of forecasts, bearish and bullish, of how Trump’s intended policies will affect the economy, and by extension, financial markets. Below are a few examples of the divergent views being expressed by thoughtful economists and experienced investors (Source: Barron’s):

The Skeptics

“Tax reform will take time, probably passing late this year. The economic impact of reduced regulations, higher infrastructure spending, and particularly tax reform won’t be felt until 2018” – Charles Krauthammer, Washington Post.

“Tax cuts work slowly and could backfire if they add to the budget deficit, deepening the deleterious effect of debt loads on growth….Similar to the fiscal stimulus package launched in 2009, “… the rush to judgment was misplaced, as widespread economic gains did not occur, and the U.S. experienced the weakest expansion in seven decades, along with lower inflation” – Lacy Hunt, Hoisington Investment Management.” – Lacy Hunt, Hoisington Investment Management.

“…Small business owners reported a much brighter outlook for the economy and higher expectations for their businesses.” – Bill Dunkelberg, Chief Economist of the National Federation of Independent Business

“Consumer sentiment is near a 12-year high and back to levels last seen before the Great Recession…” – Joshua Shapiro, chief U.S. economist at MFR.

“Fiscal stimulus and broad-based deregulation are expected to jolt the U.S. economy toward a long-term equilibrium of higher growth, inflation and interest rates.” – Deutsche Bank

The dramatic rise in equity markets since the election indicates that the “Believers” represent market consensus. Investing in line with consensus views (though comfortable) has its drawbacks, as much of the potential investment gains from those views may have already been priced into the market (i.e. the Efficient Market Hypothesis). It is therefore axiomatic that if reality veers from consensus expectations, investment losses will outweigh potential future gains.

So what are the current consensus investment themes? Several of them are listed below along with a matching non-consensus view expressed by Seinfeld’s George Costanza, who has decided to do the opposite of what he would normally do.

Sources: John Hancock and Covenant Investment Research

While George is confident in his views (because “A George, divided against itself, Cannot Stand!”), Covenant’s Chief Compliance Officer will be pleased that none of the above is intended as investment advice or a forecast of future investment returns. That being said, a properly diversified portfolio which combines exposure to traditional asset classes with non-correlated investment strategies (e.g. hedge funds, private equity, natural resources, private lending, etc.) should enable investors to participate in upside should the consensus views prove correct, while mitigating downside risk in the event the masses are wrong. Over a full business cycle, through the “magic” of compounding, a portfolio that exhibits lower downside volatility can outperform a portfolio with concentrated risks in one or two return drivers.

Weekly Economic Data Summary: The November Job Opening and Labor Turnover (JOLT) report (which is always issued with a one-month lag) supports our belief that the labor market is maturing and the best days of hiring are behind us. Job Openings (currently at 5.5mm) peaked in April ’16 at 5.8mm and have been slowing since then. The headline Retail Sales number of 0.6% for December was deceptively strong, boosted by a jump in year-end incentives on automobiles and higher gasoline prices. Control Group Sales (which excludes autos and gasoline) rose only 0.2% vs. expectations of a 0.4% increase.